Finance for IT Decision Makers: A Practical Handbook for Buyers, Sellers and Managers

214 Pages·1999·3.727 MB·English

by  Michael Blackstaff FCA, MBCS (auth.)

Practitioner Series
Springer-Verlag London Ltd.
Other titles in this series:
The Politics of Usability
L. Trenner and J. Bawa
3-540-76181-0
The Project Management Paradigm
K. Burnett
3-540-76238-8
Electronic Commerce and Business Communications
M. Chesher and R. Kaura
3-540-19930-6
Key Java
J. Hunt and A. McManus
3-540-76259-0
Distributed Applications Engineering
I. Wijegunaratne and G. Fernandez
3-540-76210-8
Publication due Autumn, 1998
Conceptual Modelling for User Interface Development
D. Benyon, D. Bental and T. Green
1-85233-009-0
Publication due Autumn, 1998
Middleware
D. Serain
1-85233-011-2
Publication due Autumn, 1998
Michael Blackstaff
Finance for IT
Decision Makers
A Practical Handbook for Buyers,
Sellers and Managers
, Springer
Michael Blackstaff, FCA MBCS
Teacher and writer on finance and information technology
Email: [email protected]
ISBN 978-3-540-76232-4
British Library Cataloguing in Publication Data
Blackstaff, Michael
Finance for IT decision makers : a practical handbook for
buyers, sellers, and managers. -(Practitioner series)
I.Business enterprises -Finance -Management
2.Corporations -Finance -Management 3.Information
technology -Management
I.Titie
658.1' 5'0880904
Library of Congress Cataloging-in-Publication Data
Blackstaff, Michael, 1939-
Finance for IT decision makers : a practical handbook for buyers,
sellers, and managers / Michael Blackstaff
p. cm. --(Practioner series)
Includes index.
ISBN 978-3-540-76232-4 ISBN 978-1-4471-0609-8 (eBook)
DOI 10.1007/978-1-4471-0609-8
1. Information technology--Finance. 2. Business enterprises--Finance.
I. Title. II. Series: Practitioner series (Springer-Verlag)
HD30.2.B555 1998
658.15--dc21 98-38348
Apart from any fair dealing for the purposes of research or private study, or criticism or review, as
permitted under the Copyright, Designs and Patents Act 1988, this publication may only be
reproduced, stored or transmitted, in any form or by any means, with the prior permission in
writing of the publishers, or in the case of reprographic reproduction in accordance with the
terms of licences issued by the Copyright Licensing Agency. Enquiries concerning reproduction
outside those terms should be sent to the publishers.
© Springer-Verlag London 1999
Originally published by Springer-V erlag London Berlin Heidelberg in 1999
Portions of various FASB documents, copyright by Financial Accounting Standards Board, 401
Merritt 7, P.O. Box 5116, Norwalk, Connecticut 06856-5116, V.S.A., are reprinted with permission.
Complete copies of these documents are available from the FASB.
The use of registered names, trademarks etc. in this publication does not imply, even in the
absence of a specific statement, that such names are exempt from the relevant laws and regula
tions and therefore free for general use.
The publisher makes no representation. express or implied. with regard to the accuracy of the
information contained in this book and cannot accept any legal responsibility or liability for any
errors or omissions that may be made.
Typesetting: lan Kingston Editorial Services, Nottingham
34/3830-543210 Printed on acid-free paper
Contents
Acknowledgements . . viii
Introduction . . . . . . ix
Part 1 Finance for IT Decision Makers
1. Decisions, Decisions 3
What is Cashflow? . . . 3
A Financial Case . . . . 4
What is Discounted Cashflow? 7
The Cost of Money ..... . 9
Present Value ....... . 9
Interpreting Present Values 13
2. Financial Cases and Business Cases 19
Cost Cases ..... 19
Cost/Benefit Cases 20
Business Cases 21
What is a Benefit? . . . 22
Cashflow and Profit . . 23
A Sound Basis for Decision Making? 27
3. When is a Benefit not a Benefit? . . . 29
How to Build an IT Financial Case 29
Example 3.1: The Situation 30
Example 3.1: The Task .. 34
Example 3.1: The Solution 35
Example 3.1: Explanations 35
What Cashflows are Relevant? 45
Is it a Worthwhile Investment? 47
4. How Financial Cases are Evaluated - Part 1 51
Present Value Revisited . . 51
The Cost of Capital .. . 52
Applying Present Values . 54
Internal Rate of Return . . . 57
NPY, IRR and Risk ........ . 62
v
vi Contents
5. How Financial Cases are Evaluated - Part 2 ............. 67
Payback ................................. 67
Payback and Risk .......................... .. 69
Discounted Payback .......................... 70
Return on Investment (ROI) . . . . . . . . . . . . . . . . . . . . .. 71
ROI and Risk .............................. 76
Shareholder Value Added ....................... 78
The Methods Compared ........................ 80
6. The Effects of Taxation . . . . . . . . . . . . . . . . . . . . . . . .. 83
Personal Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 83
Business Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 84
Capital Allowances ........................... 86
How Does Tax Affect an IT Financial Case? ............. 90
After-Tax Evaluation of an Investment ................ 93
The Results Compared ......................... 95
Taxation and Leasing . . . . . . . . . . . . . . . . . . . . . . . . .. 95
7. IT Leasing - Part 1 ........................... 99
What is a Lease? . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 99
How IT Leasing Developed . . . . . . . . . . . . . . . . . . . . . . . 10 1
Types of Lease . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
Finance Leases ............................. 105
Whose Balance Sheet? ......................... 106
Sale and Lease-Back 107
Hire Purchase .............................. 108
Leasing and Financial Cases ...................... 109
8. IT Leasing - Part 2 ........................... 111
Operating Leases ............................ 111
Residual Value (RV) .......................... 112
Whose Balance Sheet? ......................... 116
Risk and Reward ............................ 117
Non-Full-Payout Finance Leases . . . . . . . . . . . . . . . . . . . . 119
Composite Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Exchange Leases ............................ 121
Rental .................................. 121
International Financing ........................ 122
"Small Ticket" Financing . . . . . . . . . . . . . . . . . . . . . . . . 123
The Wilder Shores ofLeasing ..................... 123
9. IT Aspects of Depreciation and Budgets ............... 127
Depreciation ofIT Assets ....................... 127
Loss on Disposal ............................ 128
Depreciation of Upgradable Assets .................. 130
Budgets ................................. 131
How Much Flexibility? ......................... 132
Contents vii
Budgets and Leasing 133
Part 2 Finance Fundamentals in a Nutshell 137
10. Finance Fundamentals - Bringing it Together . . . . . . . . . . . . 139
Ways to Run a Business . . . . . . . . . . . . . . . . . . . . . . . . . 139
Limited Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
How a Business Works ....................... 142
Example 10.1: Part 1 - How Transactions Affect the
Balance Sheet . . . . . . . . . . . . . . . . . . .. ...... 143
Example 10.1: Part 2 - Typical Adjustments .... ...... 149
Example 10.1: Part 3 - The Profit and Loss Account 152
Example 10.1: Part 4 - The Cashflow Statement ........... 153
Relating Cashflow to Profit . . . . . . . . . . . . . . . . . . . . . . . 154
Published Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
11. Finance Fundamentals - Pulling it Apart .............. 161
Financial Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
Example 11.1: A Sample Company - JMB Limited . . . . . . . . . . 163
Profitability Ratios ........................... 165
Activity (or Capital Productivity) Ratios ........ . 166
Liquidity (or Cash Management) Ratios ........... 170
Gearing Ratios ......................... 171
Stock Market Ratios ...................... 172
Other Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
Shareholder Value Added ....................... 174
Appendices
1 Discount Tables 181
2 Glossary of Financial Terms . . . . . . . . . 187
3 Lease Accounting Rules ................ . 194
4 UK Software Tax and Accounting Rules . . . . 197
5 IT Aspects of UK VAT ........... . 199
6 Pro Forma Answer Sheets . . . . . . . . . . .. ...... . 202
7 Further Reading .............. . 208
Index ........................ . 211
Acknowledgements
Extracts from UK accounting standards are reproduced by kind permission
of the Accounting Standards Board.
Portions of a US Financial Accounting Standards Board (FASB) document,
copyright by Financial Accounting Standards Board, 401 Merritt 7, P.O. Box
5116, Norwalk, Connecticut 06856-5116, USA, are reprinted with permission.
Complete copies of this document are available from the FASB.
The diagram in Figure 9.2 is reproduced, slightly modified, from Lock D.
(1996) Project Management, 6th edn, page 493, Gower, Aldershot, by kind
permission of the author.
Appreciation
I should like to acknowledge with gratitude the technical help given by Mr
Richard Barfield FCA, of the Shareholder Value Services team at
PricewaterhouseCoopers in London, regarding those sections of the book
that contain references to "shareholder value added (SVA)". His suggestions
of simple ways of describing this evolving subject for the non-specialist
reader, and of how SVA might be related to more well-established ways of
evaluating investments in IT, have, I believe, added significantly to the
usefulness of the book
I should like to thank the following, whose comments and suggestions on
the drafts at various stages have been most valuable: Geoff Berridge, Jenny
Blackstaff, Colin Boyd, John Brown, Tony Dunstan, Jeff Hall, Fred Lyon,
Professor Malcolm McDonald, Brian Mann, Bill Mason, Graham Salvin and
Karen Thompson.
Finally, I should like to thank Rebecca Moore and Roger Dobbing at
Springer-Verlag London, Ian Kingston of Ian Kingston Editorial Services and
Professor Russel Winder of Kings College London, the Series Editor, for their
help, guidance, patience and courtesy during the writing and production of
this book.
viii
Introduction
Purpose
The purpose of this book is to explain to information technology (IT)
decision makers those aspects of finance that most affect their work. Most
IT decision makers belong in one of two categories. Some know a lot about
IT, but less about finance; the others know a lot about finance, but less about
IT. In my experience, those in the first category often have to make financial
decisions. Those in the second also, of course, have to make financial
decisions, but about things whose characteristics stretch the normal
financial and accounting rules up to, and sometimes beyond, their elastic
limit.
Among the characteristics of IT that provide interesting challenges for
financial people are the following:
• The accelerating rate of change
• The short and unpredictable useful life of IT assets
• The mixture of hardware, software and services
• Upgradability
• Networks that cross country boundaries
• IT jargon
Asked what characteristics of finance provide interesting challenges for IT
people, many of them would answer - "Everything". However, items in the
following selection are often particular causes of wonder:
• Leasing
• Why financial models always shrink benefits but never costs
• Being told that a company with a mountain of profit is about to fail through
lack of cash
• Discovering that their budget has been charged with £113 485.17 for
something called "loss on disposal" of an asset that was acquired before
they took the job, and that they hardly knew existed
• Being told that a subject based wholly on numbers is "an art"
• Financial jargon
This book will help to shed light on to the twilight zone where these two
disciplines meet.
ix
x Introduction
How the Book is Organized
The book consists of two parts and seven appendices. Each part stands alone,
and, with one exception, there are no references from one part to the other.
Part 1 is the main part of the book, and everything in it has direct relevance
to making decisions about IT. It should be understandable to people with little
prior knowledge of finance or accounting, while also being useful to
non-specialist financial people.
Part 2 is called "Finance fundamentals in a nutshell". It is for people who
have no prior knowledge, or who wish to brush up on the knowledge they
once had. If needed, it should be read before Part 1.
Among the appendices is a glossary of relevant British and American
financial terms.
How to Use the Book
There are many examples. They are all integrated into the text, and do not
interrupt it. Some of them stand alone; others form part of a series, helping to
build arguments step by step. The examples can also, if you wish, be treated as
exercises. Should you wish to work through them for yourself, pro forma
answer sheets are provided for some of them in Appendix 6. If you would like
a recommendation, it is that you read a chapter through, then go back and
work through some of the examples.
The principles explained in this book are applicable in most countries of
the world. In Chapter 6 I have used UK examples, but I have pointed out that
broadly similar principles apply in other countries, although with differences
of detail. The few pieces of information that are of specific relevance only to
UK readers I have put into appendices, although, at least in the case of Appen
dices 3 and 4, here too similar principles apply in many countries.